If you need money for an unexpected expense or to help pay off debt, you may be considering taking out a loan. But if you own a home, there could be another way to access additional cash to cover these expenses using your home as collateral.
One way to do this is with a cash-out refinance on your home, which lets you use the value already in your home to get money that could help you reach your financial goals. But before you start exploring a cash-out refinance, there are a few risks you need to be aware of.
What Is a Cash-Out Refinance?
With any sort of a mortgage refinance (or “refi”), your current mortgage is replaced with a new one. With traditional mortgage refinancing, you use what’s called a rate-and-term refi, which allows you to borrow about the same amount that you currently owe on your mortgage. This can often help you to get a lower interest rate and/or better terms on the remainder you still owe, which could help you to save money and pay less on your mortgage over time.
A cash-out refi is similar to a rate-and-term refi, but with cash-out refinancing, you borrow more than you currently owe on your mortgage and keep the remaining dollar difference as cash you can use however you want: to make home renovations, pay off debts, or fund a large expense. The amount you can borrow with a cash-out refi is based not on what you currently owe on the mortgage, but rather on your home’s equity.
Equity is the cash value of your home that exceeds what you currently owe. Let’s say your home is worth $250,000 and you still owe $100,000 on your current mortgage. That means that the equity in your home—or the value that exceeds the amount owed—would be $150,000.
Cash-out refi lenders will use what is called a loan-to-value (LTV) ratio to help determine your creditworthiness. An LTV ratio is calculated by comparing the value of your home with how much you mean to borrow. With a cash-out refi, lenders will usually grant you up to 80% of your home’s total loan-to-value ratio. So, using the above example, you could borrow up to $200,000 (or 80% of $250,000), put $100,000 toward your mortgage, and keep the remaining $100,000 as cash.
Why Would You Do a Cash-Out Refi?
Cash-out refinancing provides you with a large lump sum of cash that you can spend in any way you like. Sounds tempting, right? Most financial experts will encourage you, however, to use that cash for sensible reasons such as re-investing in home equity or for paying off major expenses and debts, rather than buying something indulgent like a new car or a dream vacation. Here are some of the reasons why most people do a cash-out refi.
Pay for Home Repairs
The most typical (and practical) reason a person chooses cash-out refinancing is to help pay for home improvements. Home renovations, expansions, or critical maintenance all help to increase the value of your home. So if you use your cash-out refi to pay for home improvements, you are essentially re-investing that cash back into your home equity and your financial future.
It’s worth keeping in mind, though, that a cash-out refi is not a good option if you’re thinking about paying for emergency repairs, like a leak or a collapsing roof, since the refinancing process could take up to several months and the problem will only get worse in the meantime.
Cover a Major Expense
Home improvements are not the only good reason to choose a cash-out refi, however. Major necessary or unexpected expenses can also be legitimate incentives to opt for cash-out refinancing. If you’re trying to pay off a major expense, some extra cash could be a big help.
For instance, if you have a child enrolling in college and you haven’t yet figured out how to pay for it, cash-out refinancing may be a better option than student loans, since the interest rate on a refinanced mortgage will usually be considerably lower than on a student loan. Keep in mind, though, that you’ll essentially be putting your home up as an asset in order to float your child’s education, meaning that if you fail to pay off this new mortgage, you’ll be risking the loss of your home.
Cash-out refinancing can also be used to help consolidate your debt. If you have several high-interest rate credit cards, using the cash from refinancing to pay those off will give you fewer individual accounts to worry about. You’ll still have to find a way to pay off the debt, of course, but now it will be combined with your mortgage into a single convenient monthly payment.
A mortgage is a secured loan, which generally carries a lower interest rate than a credit card. However, a secured loan also means that you could lose your assets—in this case, your home—if you don’t keep up with monthly payments.
How a Cash-Out Refi Works
Just as with your original mortgage, when you refinance on your home, there are clear steps involved in the process. Here’s what you should expect when qualifying and getting approved for a cash-out refi.
1. Provide Documentation
When you apply for a cash-out refinance, you need to provide the same sorts of documentation required for your original mortgage. This includes tax returns, W-2s, pay stubs, bank statements, and a credit report. These documents help to ensure your creditor of your borrowing worthiness.
The requirements for a cash-out refi are not quite as strict as other types of home equity loans, but you’ll need a credit score of at least 640. You will also need to demonstrate that you have a low debt-to-income (DTI) ratio, which is the difference between your gross monthly income and your recurring debt such as credit cards and student loans.
3. Prepare for Appraisal
The next step will be having an appraiser come look at your home in order to assess its value. Before this, however, you want to make sure your home is in top shape in order to maximize the equity. You may think about improving your landscaping, making sure the inside and outside of your home is clean, and making any necessary small repairs.
You also should double-check that all your plumbing, lighting, and appliances are in proper working order. And if you have the money on hand for small upgrades, it’s a good idea to make those improvements now in order to maximize your home’s equity before the appraisal process.
4. Sign Loan Documents
After the appraisal process, you’ll be approved for the loan and you will need to order the proper loan documents and set up a date to sign them with your loan agent. Bring all your documentation with you to the signing appointment, and carefully read all of the loan documents. A notary or attorney should be present at the signing to help explain any documents to you.
5. Pay Closing Costs
After you’ve been approved, you’ll be required to pay any closing costs associated with refinancing. This could include an upfront mortgage insurance premium (UFMIP), appraisal fees, and escrow fees. These costs can vary, but they could amount to hundreds or thousands of dollars, so be sure to take them into account when determining whether cash-out refinancing is right for you.
Understanding the process is key to determining if a cash-out refi is your best option. Now that you know what to expect in those initial stages, it’s time to consider whether or not the benefits outweigh the costs.
The Pros of Cash-Out Refinancing
Should you do a cash-out refi? There are many benefits to consider, such as lower interest rates. If you originally bought your home at a time when mortgage rates were higher than they are now, refinancing could lower your current interest rate.
If you apply the cash from your refi toward paying off high-interest loans and credit cards, you could end up saving money since the interest rate on a cash-out refi is oftentimes considerably lower than that associated with credit cards.
Not only will you be able to pay off your high-interest debt with a cash-out refi, you will also have more time to pay the debt back. This could take some financial pressure off you, as long as you don’t rack up more debt.
Using a cash-out refinance to pay off those high-interest accounts could also improve your credit score. Keep in mind, however, that if you fail to repay on the refinance, you’re going to be in serious risk of losing your home and your credit could take a plunge.
In addition, mortgage interest is tax deductible, which means a cash-out refi could provide you with a larger tax refund in addition to helping you lower your taxable income.
Finally, cash-out refinancing lets you borrow money for cheap. So if you need cash for home improvements, renovations, college tuition for your kids, or any other major expense, this option could be better than taking out an additional credit card or loan.
The Cons of Cash-Out Refinancing
It’s important to consider the negatives associated with cash-out refinancing as well. The most obvious risk you’ll be running with a cash-out refi is that you may lose your home if you don’t continue to make regular payments on your new mortgage.
There’s even a chance that you may actually end up with a higher interest rate than you already have, since refinancing changes the terms of your mortgage. This means refinancing could end up costing you more each month than your current mortgage.
If your interest rate is going to increase by refinancing, you’ll need to do the math and consider whether that extra cash is really worth the higher interest. Without a lower interest rate than you currently have, it’s usually better to keep your current mortgage.
As mentioned above, you’ll be required to pay for any closing costs when you refinance. Closing costs vary, but most are hundreds or thousands of dollars. If that amount is especially high in comparison to the cash you’ll be taking out, it may not prove worthwhile to do a cash-out refi.
Are you refinancing just to grab a few extra thousand dollars? The closing costs alone may make a cash-out refi not worth the trouble. Since a cash-out refi can take 15-30 years to pay off you may not want to use this option for buying short-term or luxury items, like a new car or a vacation.
Bottom line: you should really only use it toward improving your long-term financial situation, not putting yourself into greater debt and risking your home.
Alternatives to Cash-Out Refi
There are many reasonable alternatives to cash-out refi if you don’t want to refinance your mortgage but would still like to use your home equity in order to free up some cash. Depending on your unique financial situation, one of these options might work for you.
Take Out a Home Equity Line of Credit
A home equity line of credit (HELOC) is essentially like using your home equity as a credit card. With a HELOC, you’ll be approved for up to 80% of your home value that you can borrow as needed. You can borrow multiple times, and you’re free to use the credit for anything.
Since a HELOC is not refinancing, the terms of your current mortgage will remain unchanged. You’ll probably pay higher interest on a HELOC than you would with a cash-out refi, but you’re only paying on the amount of credit that you actually use, so it may end up costing you less.
Use a Home Equity Loan
A home equity loan is similar to a HELOC, but instead of borrowing only what you need multiple times, a home equity loan allows you to borrow a large, lump sum of money which you repay with fixed monthly payments. The interest rate on the loan will be set up front and should stay fixed over the course of repayment, provided you make those payments on time. As with the HELOC, a home equity loan will let you borrow on your home equity without refinancing your mortgage.
Consolidate Your Debt with a Personal Loan
If you’re considering cash-out refinancing because you have debts you want to pay off, one alternative you might consider is consolidating that debt rather than refinancing your mortgage. By consolidating your debt, you’ll have all your accounts reduced to one convenient monthly payment, and you may end up with an overall lower interest rate than you have currently.
The lender will issue the loan in a single lump sum, you use that money to pay off your debts, and you pay back the lender through a regular monthly payment. The great news here is that your home isn’t being put at risk in order to get rid of some debt.
Consider Debt Settlement
Another possible option if you’re considering a cash-out refi to tackle debts is debt settlement. The biggest difference with debt settlement is that it allows you to get out of debt without requiring you to take out a loan at all.
When you settle your debt, you or a company working for you will negotiate with your creditors to reduce the total amount of debt you owe. This option could help you save money on your debt and become debt-free faster, but you only qualify if you have $7,500 or more in credit card, personal loan, or other kinds of unsecured debt.
If you’re exploring a cash-out refi to pay off debt and are interested in learning more about debt settlement as an alternative, read this article about debt settlement now.
Or, give one of our Certified Debt Consultants a call at 800-910-0065 to learn more about our debt settlement program. Freedom Debt Relief has provided debt settlement services to over 600,000 people and settled over 10 billion dollars since 2002.
Is a Cash-Out Refi Right for You?
Cash-out refinancing is a good option if you’re able to grab a better interest rate on your mortgage and you’re planning to put the extra cash toward the right purposes. Using the cash to increase the value of your home, cover a necessary expense, or tackle high-interest debt are all sound reasons for considering a cash-out refi.
But if you just want some extra money to spend on luxuries, refinancing is not a great idea since you’re going to get very little return on that kind of spending. And when it comes to using your home as collateral, you want to make sure your financial future is a secure one. Keep in mind all of the costs, potential benefits, and options to cash-out refinancing before making any decisions.